Motley Fool | Buying on margin is a tightrope deal

Q: How does buying stocks "on margin" work? - J.M., Kalamazoo, Mich. A: It's when you invest with money borrowed from your brokerage, paying interest for the privilege. Using margin will amplify your gains - but also your losses.

Q: How does buying stocks “on margin” work?

— J.M., Kalamazoo, Mich.

A: It’s when you invest with money borrowed from your brokerage, paying interest for the privilege. Using margin will amplify your gains — but also your losses.

An extreme example: Imagine that you hold $100,000 in stocks and you borrow $100,000 on margin to invest in more stock. If your $200,000 portfolio doubles in value to $400,000, you’ll have earned an extra $100,000 (less interest expense), thanks to margin.

But if your holdings drop by 50 percent, they’ll be worth $100,000 and you’ll still owe $100,000 (plus interest). That will leave you with ... nothing. Your holdings dropped by 50 percent, but margin amplified that to a

100 percent loss. Margin cuts both ways.

Consider the interest expense, too. If you’re borrowing on margin and paying 9 percent interest, you should be pretty confident your borrowed stocks will appreciate more than 9 percent. If they fall below a certain level, you’ll receive a “margin call.” If you can’t pay the required additional money, the brokerage will sell some of your holdings to generate the cash, possibly resulting in short-term capital gains taxed at high rates.

Only experienced investors should use margin, and many have done well without ever using it.

Fool’s school: Be wary of overhyped stocks

When we run across a mailing or online post hyping a little-known stock as the next great investment, it can be hard to resist. But that’s very often the right thing to do. Most of the stocks that are breathlessly promoted are risky “penny stocks” (priced below $5 a share).

Some red flags to watch out for:

• Lots of capital letters and exclamation marks, along with appeals to your emotions. If you’re being told about “an Oil-Stock Gusher” or that a company has a deal in the works that “points to HUGE Profits for early shareholders,” be wary.

• Strangely specific claims, such as that a deal “will soon drive the stock above $20!” or that you can expect a newsletter’s future recommendations to rise more than 30 percent in less than 30 days. At such a rate of return, a $1,000 investment would grow to more than

$6.8 billion in just five years.

• An unprofessional company website. If you look up the company’s website and it features poor grammar and misspellings and pages “under construction” or absent, that’s a bad sign.

Foolish trivia

Two brothers founded me in 1871 in Ohio. Today, I’m the largest domestic pottery company, specializing in high-fired, lead-free glazes. Based in West Virginia now, I employ more than 1,100 people. For a time, I made toilet ware, such as china basins. In the early 1900s, I had the world’s largest pottery plant and boasted about 10 percent of U.S. pottery-production capacity. In the 1950s, facing competition from inexpensive imported dinnerware, I expanded into hotel and restaurant offerings. You might expect food at Spanish religious festivals to be served on my flagship dishes. Who am I?

Last week’s trivia question: Based in Tennessee, I trace my history to the 1878 founding of The Penny Press in Cleveland. I became one of the most-successful newspaper publishers and later an operator of many local television stations. I grew into one of America’s biggest cable-TV operators. I sold my cable business to Comcast. I later spun off my local television and newspaper businesses but kept my national cable-TV brands. Who am I?